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Our occasional series of comments on Dublin and what's happening to it. This month: Why the Irish Property Bubble has Already Burst
Why the Irish Property Bubble has Already Burst
[Posted 20th September 2004]
I've been predicting this since about 1997, but at that time, while it was clear to many people that an unsustainable spiral in house prices was underway, it was far from clear how it functioned, and therefore impossible to predict how far it would go and how long it would continue. Unfortunately, the mechanism is now clear and the consequences are stark...
Among those interested in this phenomenon, the recently elected Irish government wanted to find out what was happening before things got ugly and they got the boot. They commissioned Peter Bacon, a well-known economist, to investigate the housing market and come up with a way of bringing it under control.
Bacon actually came up with three reports over the following years, and only discovered the real situation in his third. Mysteriously, this report vanished from public attention almost as soon as it appeared.
I had, by a process of elimination, independently come to the same conclusions as Bacon a few months earlier, and registered as a doomsayer to anyone who would listen. The hostility and denial I encountered persuaded me that I was onto a truth which was hard for people to accept.
Normally a rising house market does not boom uncontrollably for more than a few years. Eventually the supply of money from rising salaries chokes the demand and prices start to stabilise. In Ireland, however, the price growth accelerated more the more it outpaced salary growth...
By this time, the average price of a house had long exceeded the maximum combined mortgage of a young couple on the average salary. The difference had to come from somewhere, since the financial institutions are not allowed to lend more than this.
The answer, we all know now, was private lending, mainly from parents raising equity on their own mature property. In a rising market, parents can easily leverage this wealth, giving their own kids a helping hand on to the property ladder and very likely sharing in the profits when the kids sell a few years from now.
An example. A young couple, earning an average eur35k and 30k, can raise about 170k with a mortgage, so to buy an average 270k house they borrow 100k from their parents (raised against their own 400k-valued suburban semi).
Sounds fine until you realise what's actually happened here. eur100k had just been shoved in under the bottom of the whole market, and that money does nothing but push up prices along the chain until it terminates when someone who owns their house outright (a retiring couple, a property developer) sells and takes the money out of the system.
In an attempt to help their kids, parents have simply handed 100k of the family wealth to some distant stranger who simply sold without reinvesting. They have also helped to fuel the spiral so their next kid will have even more anxiety when they come to buy.
So where does all this lead? Well, without a good answer to that you end up succumbing to the 'there is no bubble' you hear from every direction since the late 90's. Unfortunately, I have a good answer...
It's all about the parents, of course.
First, Irish parents have more kids than houses. This means that there is a limit to the number of times your parents can 'help out' with buying a house. Each time they do so, they contribute to the spiral, and as the gap between prices and mortgages rises (currently about 50/50) the limit is reached that bit more quickly.
Second, there is the investment motive. While the gap is small, and the money is reasonable, and the market is buzzing, a parent can practically guarantee a very healthy return on the loan after only a few years. As prices become more and more out of kilter with salaries, however, things start to appear a little more fraught. The bigger the gap gets, the bigger the chunk of your parents' house is exposed. Since this represents their entire wealth as they approach retirement, it starts to weigh on their minds. As the market becomes ever more overvalued, the perceived guarantee of instant profit starts to look a little more uncertain.
As exuberance inevitably gives way to caution for these reasons, the effect is a slow but inexorable withering of money supply, like a slow puncture, or more dramatically, like a small hole in a dike.
Every parent who dithers, or reluctantly withdraws their support, means a house-buyer is short half the price of the house. As the number slowly rises, the demand at a given price starts to flag, until a tipping point is reached, when the price has to drop to find more buyers. Once prices start to drop, and people start to see them drop, the trickle becomes a bursting dam and the whole edifice collapses.
Last year, I had an intuition that I had spotted when the tipping point would arise: when average house prices exceeded average ability to pay, based on average salaries. Let's say an average house costs 300k. The average salary is roughly eur35k, so the average maximum mortgage is say 175k (five times the salary). An average family has 2-3 children, so the average (300k) house-owning parent can lend say 125k to each child to buy an average 300k house. If the house price is above this, the gap is just a little bigger than the amount available to the parents (they have to divide their money up).
So a certain line is crossed when this price is reached, and after this the growth is pegged to roughly the salary growth. This line was crossed in March of 2004, when the price reached 300k.
The house price growth rate, after four months around 11%, dropped in one month to 5% where it has remained for six months.
Now parents see the growth rate halving overnight, so their profit forecast is slashed. They see that they are at the limit of their own ability to support their kids and only then by exposing all of the wealth they depend on for their retirement. They get even more concerned. One by one, they pull out, sucking 100k or more out of the bottom of the market.
Suddenly a growing number of buyers have much less to spend than a few months back. Sellers in a hurry will have to drop prices or hang on and wait for the last of the big spenders. Eventually prices will start to drop in big jumps as the first-time buyers no longer have the necessary. This will of course spook any prents still thinking about it to forget about it.
I hope I'm wrong, but please tell me how I could be.